The ITC's USMCA Report: The ISDS Section

The Commission’s quantitative assessment of the ISDS provisions sought to identify how the changes in ISDS provisions could affect the U.S. economy as well as different sectors. This section starts with a review of the related literature and opinions from industry representatives assessing the impact of ISDS provisions. Next, it describes the analytical framework used by the Commission to assess the effect of changes in ISDS provisions under USMCA compared to NAFTA. It will conclude with a summary of the modeling results, which suggest that capital used by U.S. foreign affiliates in Mexico is likely to be marginally redirected back into the United States, ultimately increasing output in U.S. manufacturing more than in other sectors that were considered.

Literature Review and Summary of Information from the Commission’s Public Hearing

This section reviews the economic literature that is relevant to assessing the impact of ISDS provisions. In addition to the economic literature, the Commission also considered information obtained at the Commission’s public hearing held on November 15–16, 2018, regarding industry concerns on the change of ISDS provisions under USMCA.

The literature generally finds that bilateral investment treaties (BITs), of which ISDS provisions form a crucial part, increase investment, though a substantial minority of papers find no effect. Recent findings help explain this discrepancy by demonstrating the importance of host country conditions and the specific provisions included in the agreement itself. As discussed in the literature review below, the effects of BITs are strongest when the recipient of the investment is a developing or transition economy. Market risk and financial system development are also important determinants, as is the sector of the investment, and even the type of investment. Among BITs provisions, ISDS and national treatment have been shown to have important effects in some studies. The effects of ISDS are central to assessing the impact of USMCA. As discussed below, however, there is conflicting evidence on the impact of ISDS provisions alone on investment. Several authors have found that ISDS provisions form a crucial part of BITs, and that they increase BITs’ credibility and effectiveness (Wälde 2005, Allee and Peinhardt, 2011, Oldenski, 2015). As such, there is an implicit, but logical, connection between improved ISDS provisions (which would theoretically enhance the credibility of an effective BIT) andinvestment behavior.

The impact of BITs on investment was estimated in several studies. Egger and Merlo (2007) assess the impact of ratified BITs on bilateral outward stocks of FDI, and find that in the short run, the ratification of BITs is correlated with a 4.8 percent increase in outward FDI stock, while the long-run effect amounts to about 8.9 percent. Berger et al. (2011) find that the impact of BITs on FDI depends significantly upon whether the transition countries in Central and Eastern Europe are included in the sample. The authors find that BITs do stimulate FDI flows. However, the impact of BITs on FDI becomes insignificant once transition economies are excluded from the sample. The authors further argue that the reason why BITs were an effective means to attract FDI to the transition countries studied is probably that such countries “lacked any reputation concerning the credibility of unilateral FDI-related measures.” Similarly, Busse et al. (2010) use a gravity-type model and find that BITs facilitate FDI flows to developing countries, and may even substitute for weak domestic institutions in the host country. Sirr, Garvey, and Gallagher (2017) investigate the impact of BITs on U.S. FDI, and find that BITs are positively related to vertical FDI. Their findings also demonstrate that BITs have a more positive effect on vertical FDI in countries with higher expropriation risk, poorer law and order, and lower government stability.

However, there is no conclusive evidence that BITs signed between advanced economies could promote investment. Citing the conclusion from a 2013 study assessing the potential benefits to the United Kingdom of including ISDS provisions in a trade agreement with the United States, Oldenski (2015) states that the benefits would not be large because “the US government assesses the UK as a very safe place to invest,” even without additional ISDS provisions. That 2013 study (Skovgaard Poulsen et al. 2013) finds it unlikely that U.S. investors looking to invest in the United Kingdom will “…factor in the existence of an EU-US investment protection treaty when deciding whether to invest in the United Kingdom.” However, Oldenski further states that evidence from literature does suggest that “packages of investment protections, of which ISDS provisions are a key part, encourage FDI.”

Though economic literature suggests that ISDS serves as a key credibility-enhancing mechanism in BITs, and that BITs promote FDI to developing countries, the economic literature directly assessing the impact of ISDS provisions on FDI flows does not find consistent results of such an impact. For example, Berger et al. (2011) attribute the positive effects of BITs on FDI mainly to ISDS provisions; nevertheless, they conclude that the effectiveness of this relationship is sensitive to the exact specification of effective ISDS. Berger et al. (2013) find that the presence of national treatment provisions has a strong and positive relationship with FDI flows, while ISDS provisions appear to play a much weaker role.

Apart from the economic literature finding evidence that BITs, of which ISDS is a key part, do promote FDI between advanced economies and developing countries, industry representatives have been consistently opposed to ISDS limitations throughout the USMCA negotiations. They have characterized them as “poison pills” from the beginning of the negotiations, have expressed reservations about the ISDS negotiating results, characterizing them as a notable step backwards, and have recommended that the new provisions not be precedents for future FTAs. One exception is the American Petroleum Institute (API), who expressed support for the new ISDS provisions. The API represents the oil and gas industry, which is exempted from the new ISDS limitations between the United States and Mexico.

Brzytwa (2018), of the American Chemistry Council, states that ISDS is a valuable mechanism because “it gives ACC member companies recourse when local courts have not addressed the problem.” He also makes the point that most of the benefits of ISDS are not visible, as they serve as deterrents to host countries who might otherwise impose rules that are prohibited by the agreements. As such, it is through its existence, not its actual use, that ISDS would “prevent the investment barriers from happening.” Furthermore, industry representatives from the food and agriculture sector indicate that the scale-back of ISDS between the United States and Mexico would create additional business uncertainty for companies with plans to set up a processing plant in Mexico. When it comes to the services industry—the financial services industry in particular—industry representatives state that the overall effect is mixed for them, as there are “some important improvements but also some negative outcomes.”

Commission’s Estimates on the Effect of Changes in ISDS Provisions

The Commission’s economy-wide simulation takes into consideration the effects of the scale-back of ISDS on the United States. The Commission used the econometric estimate from Egger and Merlo (2007) that the ratification of BITs is correlated with a 4.8 percent increase of outward FDI stock in the short run. The Commission’s analysis assumes that the removal of a BIT reduces outward FDI stock by the same amount. Given that ample economic studies have found that ISDS is a key part of BITs—one of the components that makes these treaties enforceable, particularly between advanced economies and developing countries—a more restricted ISDS is likely to reduce outward FDI stock and corresponding foreign affiliate sales (FAS) in the host country. However, since the 4.8 percent represents the effects ofthe removal of BITs, of which ISDS is only a part, the impact of ISDS alone on FDI is likely to be lower. Therefore, the assumption that USMCA’s reduction in the scope of ISDS results in a 4.8 percent drop in the stock of FDI likely overestimates the impact of this change in the Commission’s economy-wide model (presented in Chapter 2). Even if overstated, however, the results detailed below show that the reduction in the scope of ISDS would have a limited economy-wide effect on the United States.

The Commission’s analysis uses the GTAP-FDI model (see appendix J) to translate the reduction in FDI in Mexico in all sectors, except the five exempted sectors, into estimated changes in productivity and capital expenditure in each country. The GTAP-FDI model is a computable general equilibrium model which incorporates FDI stock and FAS data. It is a comparative static, multiregional, and multisector model which differentiates between domestic and foreign firms on both the demand side and the supply side. One of the strengths of such a model is that it can be used to estimate the economy-wide and sectoral effects of changes in individual countries’ FDI policies and/or investment provisions within an FTA. For this analysis, the base year of the model was updated from 2014 to 2017. Data on U.S. FAS to Canada and Mexico were updated to 2016, the latest years for which data were available.

The results from the GTAP-FDI model indicate that a portion of the FDI will be redirected into the U.S. economy. Note, however, that the results discussed in this section reflect only the impact of the ISDS provisions and may not reflect the full impact of USMCA, which is discussed in chapter 2. The GTAP-FDI model estimates that overall (foreign and domestic) capital investment in Mexico will decline by up to 0.44 percent ($2.9 billion). U.S. investors would respond, in part, by increasing investment in the United States, and in other foreign markets with perhaps better investment protections. According to the model, the U.S. portion of the reinvestment would generate a small increase in output in the U.S. manufacturing and mining sector by up to 0.03 percent ($1.3 billion). This increase in output would be brought about by the increasing amount of capital available in the United States for investing in those domestic manufacturing and mining industries.

Limitations on ISDS provisions would also result in an expansion of capital expenditure in the United States. The estimated changes in productivity and capital expenditure are included in the main economy-wide simulation (see chapter 2).

Economists and political scientists (i.e., people good with statistics!) are going to have a field day with this, but while the conclusions can be critiqued, they probably can't be disproved effectively. There's really no good way to disentangle the impact of all the various economic and social policies that are being implemented, in order to separate out the effect of changes to ISDS from NAFTA to USMCA. If the ITC had wanted to, it could have cited to different studies and come up with a different number. But this is where they ended up: "According to the model, the U.S. portion of the reinvestment would generate a small increase in output in the U.S. manufacturing and mining sector by up to 0.03 percent ($1.3 billion)."

Comments

The Commission’s quantitative assessment of the ISDS provisions sought to identify how the changes in ISDS provisions could affect the U.S. economy as well as different sectors. This section starts with a review of the related literature and opinions from industry representatives assessing the impact of ISDS provisions. Next, it describes the analytical framework used by the Commission to assess the effect of changes in ISDS provisions under USMCA compared to NAFTA. It will conclude with a summary of the modeling results, which suggest that capital used by U.S. foreign affiliates in Mexico is likely to be marginally redirected back into the United States, ultimately increasing output in U.S. manufacturing more than in other sectors that were considered.

Literature Review and Summary of Information from the Commission’s Public Hearing

This section reviews the economic literature that is relevant to assessing the impact of ISDS provisions. In addition to the economic literature, the Commission also considered information obtained at the Commission’s public hearing held on November 15–16, 2018, regarding industry concerns on the change of ISDS provisions under USMCA.

The literature generally finds that bilateral investment treaties (BITs), of which ISDS provisions form a crucial part, increase investment, though a substantial minority of papers find no effect. Recent findings help explain this discrepancy by demonstrating the importance of host country conditions and the specific provisions included in the agreement itself. As discussed in the literature review below, the effects of BITs are strongest when the recipient of the investment is a developing or transition economy. Market risk and financial system development are also important determinants, as is the sector of the investment, and even the type of investment. Among BITs provisions, ISDS and national treatment have been shown to have important effects in some studies. The effects of ISDS are central to assessing the impact of USMCA. As discussed below, however, there is conflicting evidence on the impact of ISDS provisions alone on investment. Several authors have found that ISDS provisions form a crucial part of BITs, and that they increase BITs’ credibility and effectiveness (Wälde 2005, Allee and Peinhardt, 2011, Oldenski, 2015). As such, there is an implicit, but logical, connection between improved ISDS provisions (which would theoretically enhance the credibility of an effective BIT) andinvestment behavior.

The impact of BITs on investment was estimated in several studies. Egger and Merlo (2007) assess the impact of ratified BITs on bilateral outward stocks of FDI, and find that in the short run, the ratification of BITs is correlated with a 4.8 percent increase in outward FDI stock, while the long-run effect amounts to about 8.9 percent. Berger et al. (2011) find that the impact of BITs on FDI depends significantly upon whether the transition countries in Central and Eastern Europe are included in the sample. The authors find that BITs do stimulate FDI flows. However, the impact of BITs on FDI becomes insignificant once transition economies are excluded from the sample. The authors further argue that the reason why BITs were an effective means to attract FDI to the transition countries studied is probably that such countries “lacked any reputation concerning the credibility of unilateral FDI-related measures.” Similarly, Busse et al. (2010) use a gravity-type model and find that BITs facilitate FDI flows to developing countries, and may even substitute for weak domestic institutions in the host country. Sirr, Garvey, and Gallagher (2017) investigate the impact of BITs on U.S. FDI, and find that BITs are positively related to vertical FDI. Their findings also demonstrate that BITs have a more positive effect on vertical FDI in countries with higher expropriation risk, poorer law and order, and lower government stability.

However, there is no conclusive evidence that BITs signed between advanced economies could promote investment. Citing the conclusion from a 2013 study assessing the potential benefits to the United Kingdom of including ISDS provisions in a trade agreement with the United States, Oldenski (2015) states that the benefits would not be large because “the US government assesses the UK as a very safe place to invest,” even without additional ISDS provisions. That 2013 study (Skovgaard Poulsen et al. 2013) finds it unlikely that U.S. investors looking to invest in the United Kingdom will “…factor in the existence of an EU-US investment protection treaty when deciding whether to invest in the United Kingdom.” However, Oldenski further states that evidence from literature does suggest that “packages of investment protections, of which ISDS provisions are a key part, encourage FDI.”

Though economic literature suggests that ISDS serves as a key credibility-enhancing mechanism in BITs, and that BITs promote FDI to developing countries, the economic literature directly assessing the impact of ISDS provisions on FDI flows does not find consistent results of such an impact. For example, Berger et al. (2011) attribute the positive effects of BITs on FDI mainly to ISDS provisions; nevertheless, they conclude that the effectiveness of this relationship is sensitive to the exact specification of effective ISDS. Berger et al. (2013) find that the presence of national treatment provisions has a strong and positive relationship with FDI flows, while ISDS provisions appear to play a much weaker role.

Apart from the economic literature finding evidence that BITs, of which ISDS is a key part, do promote FDI between advanced economies and developing countries, industry representatives have been consistently opposed to ISDS limitations throughout the USMCA negotiations. They have characterized them as “poison pills” from the beginning of the negotiations, have expressed reservations about the ISDS negotiating results, characterizing them as a notable step backwards, and have recommended that the new provisions not be precedents for future FTAs. One exception is the American Petroleum Institute (API), who expressed support for the new ISDS provisions. The API represents the oil and gas industry, which is exempted from the new ISDS limitations between the United States and Mexico.

Brzytwa (2018), of the American Chemistry Council, states that ISDS is a valuable mechanism because “it gives ACC member companies recourse when local courts have not addressed the problem.” He also makes the point that most of the benefits of ISDS are not visible, as they serve as deterrents to host countries who might otherwise impose rules that are prohibited by the agreements. As such, it is through its existence, not its actual use, that ISDS would “prevent the investment barriers from happening.” Furthermore, industry representatives from the food and agriculture sector indicate that the scale-back of ISDS between the United States and Mexico would create additional business uncertainty for companies with plans to set up a processing plant in Mexico. When it comes to the services industry—the financial services industry in particular—industry representatives state that the overall effect is mixed for them, as there are “some important improvements but also some negative outcomes.”

Commission’s Estimates on the Effect of Changes in ISDS Provisions

The Commission’s economy-wide simulation takes into consideration the effects of the scale-back of ISDS on the United States. The Commission used the econometric estimate from Egger and Merlo (2007) that the ratification of BITs is correlated with a 4.8 percent increase of outward FDI stock in the short run. The Commission’s analysis assumes that the removal of a BIT reduces outward FDI stock by the same amount. Given that ample economic studies have found that ISDS is a key part of BITs—one of the components that makes these treaties enforceable, particularly between advanced economies and developing countries—a more restricted ISDS is likely to reduce outward FDI stock and corresponding foreign affiliate sales (FAS) in the host country. However, since the 4.8 percent represents the effects ofthe removal of BITs, of which ISDS is only a part, the impact of ISDS alone on FDI is likely to be lower. Therefore, the assumption that USMCA’s reduction in the scope of ISDS results in a 4.8 percent drop in the stock of FDI likely overestimates the impact of this change in the Commission’s economy-wide model (presented in Chapter 2). Even if overstated, however, the results detailed below show that the reduction in the scope of ISDS would have a limited economy-wide effect on the United States.

The Commission’s analysis uses the GTAP-FDI model (see appendix J) to translate the reduction in FDI in Mexico in all sectors, except the five exempted sectors, into estimated changes in productivity and capital expenditure in each country. The GTAP-FDI model is a computable general equilibrium model which incorporates FDI stock and FAS data. It is a comparative static, multiregional, and multisector model which differentiates between domestic and foreign firms on both the demand side and the supply side. One of the strengths of such a model is that it can be used to estimate the economy-wide and sectoral effects of changes in individual countries’ FDI policies and/or investment provisions within an FTA. For this analysis, the base year of the model was updated from 2014 to 2017. Data on U.S. FAS to Canada and Mexico were updated to 2016, the latest years for which data were available.

The results from the GTAP-FDI model indicate that a portion of the FDI will be redirected into the U.S. economy. Note, however, that the results discussed in this section reflect only the impact of the ISDS provisions and may not reflect the full impact of USMCA, which is discussed in chapter 2. The GTAP-FDI model estimates that overall (foreign and domestic) capital investment in Mexico will decline by up to 0.44 percent ($2.9 billion). U.S. investors would respond, in part, by increasing investment in the United States, and in other foreign markets with perhaps better investment protections. According to the model, the U.S. portion of the reinvestment would generate a small increase in output in the U.S. manufacturing and mining sector by up to 0.03 percent ($1.3 billion). This increase in output would be brought about by the increasing amount of capital available in the United States for investing in those domestic manufacturing and mining industries.

Limitations on ISDS provisions would also result in an expansion of capital expenditure in the United States. The estimated changes in productivity and capital expenditure are included in the main economy-wide simulation (see chapter 2).

Economists and political scientists (i.e., people good with statistics!) are going to have a field day with this, but while the conclusions can be critiqued, they probably can't be disproved effectively. There's really no good way to disentangle the impact of all the various economic and social policies that are being implemented, in order to separate out the effect of changes to ISDS from NAFTA to USMCA. If the ITC had wanted to, it could have cited to different studies and come up with a different number. But this is where they ended up: "According to the model, the U.S. portion of the reinvestment would generate a small increase in output in the U.S. manufacturing and mining sector by up to 0.03 percent ($1.3 billion)."